Shortrunandlongruncosts

Short Run and Long Run Costs

Chapter 5 Pages 178-191

What would you need to start a Panera? http://www.panerabread.com/about/franchise/

Short Run versus Long Run?

short run - a period of time where some inputs are fixed (capital = building, equipment, etc.)

long run - a period of time in which all inputs can be varied (no inputs are fixed)

Short Run Cost Function

Definition: A function that defines the minimum

possible cost of producing each output level when variable factors are employed in the cost-minimizing fashion

In this case, what is your total product/output (Q)? Number of Paninis (for simplicity assume

that Panera only produces a single product)

In general a firm uses capital, labor and materials to produce the product/output.

In Short Run, how does the number of Paninis produced change as you change the number of workers?

# of workers # of paninis

How does output change if you hire one more person? Depends on how many workers you

currently have. Output increase by 5 paninis when you hire the 1st worker, increases by 7 paninis when you hire the 2nd worker, …., and increases 3 paninis when you hire the 5th worker.

What happens to “productivity” as the first few employees are hired?

Specialize and marginal product increases.

Marginal Product is the change in total output attributable to the last unit of an input.

What would happen to “productivity” if you continued to hire more and more workers?

Marginal product would start to fall because some inputs are fixed in the short run

Law of diminishing marginal returns OR Law of diminishing marginal product

What costs would you have to pay even if you didn’t produce a single panini?

Fixed Costs, FC (or Total Fixed Costs, TFC)

(often involves building and equipment)

Fixed Costs = Costs that do not change with changes in output

What costs would you have to pay only if you produced paninis?

Variable Costs, VC (or Total Variable Costs, TVC)

(often assumed to be labor and material)

Variable Costs = Costs that change with changes in output

What costs would increase if we wanted to produce one more panini?Variable Costs (such as labor

and materials)

If you hired more and more employees and the store became more and more

crowded until the marginal product of a worker started to fall, what would happen to the cost of producing one more panini (marginal cost)?

Marginal cost = cost of producing an additional unit of output

CostsQ FC VC TC AFC AVC ATC MC

0 100 0 100 - - - 50

1 100 50 150 100 50 150

2 100 80 180 50 40 90

3 100 100 200 33.3 33.33 66.7

4 100 110 210 25 27.5 52.5

5 100 130 230 20 26 46

Costs Q FC VC TC AFC AVC ATC MC

5 100 130 230 20 26 46

6 100 160 260 16.7 26.67 43.3

7 100 200 300 14.3 28.57 42.9

8 100 250 350 12.5 31.25 43.8

9 100 310 410 11.1 34.44 45.6

10 100 380 480 10 38 48

Q AFC AVC ATC MC 0 - - - 50

1 100.00 50.00 150.00 30

2 50.00 40.00 90.00 20

3 33.33 33.33 66.67 10

4 25.00 27.50 52.50 20

5 20.00 26.00 46.00 30

6 16.67 26.67 43.33 40

7 14.29 28.57 42.86 50

8 12.50 31.25 43.75 60

9 11.11 34.44 45.56 70

10 10.00 38.00 48.00

0 1 2 3 4 5 6 7 8 9 10

What is happening to TC as Q increases? TC= ATC*Q

150180

Increases!

Q AFC AVC ATC MC0 - - -

501 100.00 50.00 150.00

302 50.00 40.00 90.00

203 33.33 33.33 66.67

104 25.00 27.50 52.50

205 20.00 26.00 46.00

306 16.67 26.67 43.33

407 14.29 28.57 42.86

508 12.50 31.25 43.75

609 11.11 34.44 45.56

7010 10.00 38.00 48.00

0 1 2 3 4 5 6 7 8 9 10

What are total fixed costs in this example? AFC*Q

100*1=100

501 100.00 50.00 150.00

302 50.00 40.00 90.00

203 33.33 33.33 66.67

104 25.00 27.50 52.50

205 20.00 26.00 46.00

306 16.67 26.67 43.33

407 14.29 28.57 42.86

508 12.50 31.25 43.75

609 11.11 34.44 45.56

7010 10.00 38.00 48.00

0 1 2 3 4 5 6 7 8 9 10

Why are AFC diminishing? Spreading a fixed number out over a larger and larger Q

501 100.00 50.00 150.00

302 50.00 40.00 90.00

203 33.33 33.33 66.67

104 25.00 27.50 52.50

205 20.00 26.00 46.00

306 16.67 26.67 43.33

407 14.29 28.57 42.86

508 12.50 31.25 43.75

609 11.11 34.44 45.56

7010 10.00 38.00 48.00

0 1 2 3 4 5 6 7 8 9 10

Why is AVC getting closer to ATC?

Because ATC = AVC+AFCand AFC is getting close to 0

501 100.00 50.00 150.00

302 50.00 40.00 90.00

203 33.33 33.33 66.67

104 25.00 27.50 52.50

205 20.00 26.00 46.00

306 16.67 26.67 43.33

407 14.29 28.57 42.86

508 12.50 31.25 43.75

609 11.11 34.44 45.56

7010 10.00 38.00 48.00

0 1 2 3 4 5 6 7 8 9 10

Where does the law of diminishing marginal product set in and how do you know? Between Q = 4 and Q = 5

MC start increasing!

Why does this happen?An input is fixed in the short run!

Where does MC cross ATC?Where does MC cross AVC?

1000 1 2 3 4 5 6 7 8 9 10

At their minimums

What is the relationship between MC and ATC? MC and AVC?

If MC<ATC, ATC is decreasingIf MC>ATC, ATC is increasingSame for AVC

501 100.00 50.00 150.00

302 50.00 40.00 90.00

203 33.33 33.33 66.67

104 25.00 27.50 52.50

205 20.00 26.00 46.00

306 16.67 26.67 43.33

407 14.29 28.57 42.86

508 12.50 31.25 43.75

609 11.11 34.44 45.56

7010 10.00 38.00 48.00

0 1 2 3 4 5 6 7 8 9 10

How do you know this is the short run?

There are fixed costs

Fixed Cost versus Sunk CostFixed Cost = costs that do not change with changes in

outputSunk Cost= a cost that is forever lost after it has been paid

Does profit maximizing output depend on whether cost if fixed or sunk given that you produce paninis?

Does the decision whether to produce any paninis depend on whether cost is fixed or sunk?

Short Run versus Long Run?

short run - a period of time where some inputs are fixed (capital = building, equipment, etc.)

long run - a period of time in which all inputs can be varied (no inputs are fixed)

Returns to Scale in Long Run Production Is the increase in output proportional to the

increase in “inputs”? What is the marginal product of changing

ALL inputs?

Economies to Scale

Exist when long-run average costs decline as output is increased.

Example in other words: to double output, you don’t have to double costs

Example in other words: if you double costs, you more than double the output

Why does there exist Economies of Scale? Specialization in production - get more

productive if specialize Can spread some costs over everything

(ex: advertising, R&D, capital investments)

Can command quantity discounts from suppliers

Diseconomies of Scale

Exist when long-run average costs rise as output is increased.

Example in other words: to double output, you have to more than double costs

Example in other words: if you double costs, you cannot double the output

Why Diseconomies of Scale?

Monitoring Morale Ex:

Constant Returns to Scale

Exist when long-run average costs remain constant as output is increased.

Example in other words: to double output, you have to double costs

Specific Example: Each of the following represent SATC curves at 3 different factory sizes that are

fixed in the short run: Short Run -At least one input

is fixed. Typically assume capital is fixed and labor/material is variable.

• Why do the ATC curves have the U-shape?

Law of diminishing marginal returns to variable input

Long Run - Nothing is fixed. Each of the following

represents a short run SATC curve at different levels of capital (building, equipment)

0 1 2 3 4 5 6 7 8 9 10 11 12

Small FactoryMedium Factory

Large Factory

Specific Example: Each of the following represent SATC curves at 3 different factory sizes that are

fixed in the short run: Suppose we initially

have a small factory and we’re producing one unit of output. If we want to increase output in the short run, how do we have to do it?

add more variable inputs

In the long run, is that the only option?

No, build a bigger factory

0 1 2 3 4 5 6 7 8 9 10 11 12

Large Factory

Specific Example: 3 possible factory sizes

The least expensive way to produce Q = 1 is with a ___________ factory.

0 1 2 3 4 5 6 7 8 9 10 11 12

Large Factory

medium

In the long run, you can choose any size factory you want...what is the LATC curve?

0 1 2 3 4 5 6 7 8 9 10 11 12

Large Factory

LATC = Minimum of the SATCs!

LATC ≤ SATC

Where do Economies of Scale exist?

0 1 2 3 4 5 6 7 8 9 10 11 12

Large Factory

Economies of Scale

Where do Diseconomies of Scale exist?

0 1 2 3 4 5 6 7 8 9 10 11 12

Large Factory

General Example – many possible levels of fixed inputs

If these are many SATC, what does the LATC look like?

LATC - minimum of SATC

Why does the LATC curve have the U-shape?

Economies of ScaleConstant Returns to Scale

Minimum Efficient Scale - lowest average costs

Shortrunandlongruncosts

total fixed costs

long run costs chapter

average costs

double costs example

sunk cost fixed cost

double output

total variable costs

output sunk cost

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